The India-Mauritius treaty (IM treaty) has had a chequered destiny and has been the centre of many a storm. The treaty came into being in 1983 and has been a fulcrum for investment flows into India since the economy was opened up to foreign investment in the early 1990s.
Availability of capital gains tax exemption under the IM treaty was first challenged at the dawn of this millennium (in 2001) and the news of the same caused a notable downward spiral in the Sensex. This resulted in the government issuing what is probably the most famous revenue circular in Indian history, Circular 789—assuring investors the benefits of capital gains exemption under the treaty. Circular 789 was ultimately upheld by the Supreme Court in the Azadi Bachao Andolan case after a period of technical debate and controversy and Mauritius continued to be a preferred jurisdiction for investments being made in India.
However, the treaty with the island country has continued to be a subject matter of on-going litigation, resulting in continued and increasing anxiety for the international investor community. It was also a cause of concern for various governments and remained at the centre of multiple controversies and allegations of treaty abuse and round tripping of funds.
Over the years, there has been a shift in point of view of global governments on certain historic tax practices and norms, with the OECD’s Base Erosion and Profit Shifting (BEPS) project, recognising that tax treaties are intended to avoid double tax, and that they should not be used as a basis for double non-taxation (where income ends up not being taxed in either the source country or resident country).
India has been intensively involved in BEPS projects. Action 6-‘Treaty abuse’-recommends that countries make a clear statement that they intend to prevent tax avoidance and especially treaty shopping while entering into a treaty as a minimum standard. India has already introduced General Anti Avoidance Rules (GAAR) in the statute books since 2012. These rules come into effect on April 1, 2017. The finance minister, Arun Jaitley, in his Budget FY17 speech, re-iterated India’s commitment to implement GAAR with effect from April 1, 2017.
Thus, while entering into the IM treaty in 1982, promoting commercial trade may have largely influenced the bargaining process of granting capital gain exemption in India to investment structures set-up in Mauritius; today, eliminating the double non taxation has become the primary focus of the government.
As a culmination of close to several years of efforts towards the re-negotiation of the treaty, the present government announced the signing of a protocol effectively withdrawing the most significant benefit enjoyed by the investor community, the exemption of capital gains on shares in Indian companies. Soon after the press release of the Indian government, the text of the protocol was released by the Mauritius government into the public domain.
A review of the same indicates that the debate on whether treaty shopping is tax planning or tax avoidance, has now largely been obviated in the context of share investment from Mauritius since after re-negotiation, India gets taxing rights on capital gain income arising on shares of an Indian company acquired on or after April 1, 2017. The government while withdrawing the exemption has approached the same in a responsible and mature fashion.
Share investments made up to March 31, 2017, are fully grandfathered under the amended treaty. This is of special import given the government’s stated intention in the 2015 Budget of grandfathering all investments up to March 31, 2017, from the application of GAAR as well.
Additionally, a 50% concession to domestic income-tax rate has been granted up to March 31, 2019, before investors equip themselves under a taxable treaty era. However, this concession would be subject to motive and bona fide business test, i.e., limitation of benefits (LOB) rule which is largely similar to the one presently under India Singapore tax treaty (IS treaty).
Capital gain income on other investments such as units, debt securities, derivatives, etc. still appear to enjoy the exempt treaty regime without any requirement to satisfy LOB, though susceptible to GAAR once effective. It is worth noting that India has similar capital gains taxation provisions with a multitude of countries including Japan, Ireland, Luxembourg, Switzerland, etc and indeed even in its treaty with Singapore (prior to its amendment in line with the Mauritius treaty, granting full capital gains exemption to Singapore tax residents).
Simultaneously, a reduced rate of tax of 7.5% has been introduced on new debt claims on or after April 1, 2017, for all investors, including banks. Viewed solely from a tax perspective, this makes Mauritius a very attractive jurisdiction for debt investments into India (historically, this has not been the case as interest income was taxed at domestic tax rates for investors/lenders other than Mauritius banks). Apart from Mauritius, Singapore is another jurisdiction which has been a large investor of capital into India. The capital gain exemption under the IS treaty is currently dependent on the exemption under the IM treaty. Thus, the potential domino effect of the withdrawal of capital gains exemption in the IM treaty is a similar withdrawal of the same in the context of the Singapore treaty, however, without the temperance negotiated in the context of the Mauritius treaty, i.e., the grandfathering and transitional period provisions.
Recent announcements suggest that the government is in the process of renegotiating the IS treaty as well. It would be interesting to see whether the amendments would be on a par with Mauritius or not.
Assuming that both the treaties are amended to be on a par, effective April 1, 2019, the tax cost of the investors investing in India would increase. The government has said that it is desirous that investors come to India on the basis of the returns investment in the country provides, not on account of tax considerations. In a sense, it is attempting to remove tax arbitrages and create a uniform playing field for investors investing capital in India.
Time will tell whether the fears of factions predicting the reduction of foreign investment in India on account of the increased tax cost after April1 1, 2017/2019, hold true or it encourages the inflow as a result of a more stable and transparent tax regime in the long run. India’s pace of growth and development would definitely influence the latter scenario.
The author is tax leader for financial services, EY. Views are personal